Deflation: Why Europe’s Problem Is Everyone’s Problem

Deflationary forces have been kicking up turbulence in Europe, prodding eurozone leaders to finally embrace quantitative easing (QE) as a way to drive economic growth. The facts became undeniably clear when December reports showed that the eurozone dipped to a -0.2% inflation rate year-to-year. For the first time since 2009, the eurozone’s inflation rate was officially in the red, bringing Europe’s anemic recovery effort front and center.

“Europe is 25% of the global market,” adds Mauro Guillén, Wharton management professor and director of The Lauder Institute. “The U.S. and China sell in Europe. The problem is essentially that deflation will produce very slow growth worldwide.”

A Healthy Benchmark

What’s widely accepted as a healthy benchmark for a country’s inflation rate is 2%. Currently, onlyone-fourth of the world’s 90 economies are below 1% and half of those are in deflation, according to a report from consultancy Capital Economics. “No major economy is facing a lot of inflation. Even the U.S. is facing contained inflation,” says Olivier Chatain, strategy and business policy professor at HEC business school in Paris and senior fellow at Wharton’s Mack Institute for Innovation Management.

Deflation is when general price levels fall; essentially, goods and services become cheaper because their prices are not rising due to a lack of inflation. Companies make smaller profits, decreasing cash flow. Consequently, this can result in layoffs and freeze any new hiring, thereby increasing unemployment. Deflation was a major cause of the Great Depression in the U.S. and stagnation in Japan over the last two decades.

“Wages do not typically fall by as much as prices in the industries facing weaker consumer demand,” explains Kent Smetters, a Wharton business economics and public policy professor. “That asymmetry produces more unemployment since producers must lay off workers rather than pay everyone a bit less.”

Moreover, consumers have less money to spend, thereby driving down the demand for goods and services, causing a surplus in goods. Another scenario is “consumer deferral” when people wait to buy something, like a new couch, betting on the possibility that prices will come down later. As a result, goods don’t move very quickly in the marketplace. Also, financiers wait on making investments, banking on prices dropping further. Loans are also more expensive to pay back as the value of money drops.

“Europe is big enough to effectively ‘export’ its deflationary problem to the rest of the world.”–Krista Schwarz

“As European prices fall, imports of European goods become cheaper. Maybe more importantly, the QE that the European Central Bank is undertaking is designed to weaken the euro,” Schwarz notes. “That makes imports into Europe more expensive and drives inflation up in Europe. But it makes European imports into the U.S. cheaper and drives inflation down in the U.S. The effect is potentially quite large.”

However, the QE announcement was welcome news for Europe’s trading partners. U.S. Federal Reserve officials signaled support for it because in the longer term, it’s in the interest of the U.S. to have a healthier European economy, adds Schwarz.

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Falling oil prices also compound the deflationary effects of the eurozone’s flailing economies, says Schwarz. Oil prices have dropped by 60% since June of last year. “The extra deflationary effect from falling oil prices is likely to be transitory, but Europe is a long way from its 2% inflation target.” Other factors, such as the eurozone unemployment rate averaging 11.5%, don’t help pave a smooth road to recovery.

Will QE Help?

As an antidote to deflation, the European Central Bank (ECB) said that its own QE program will be rolled out in March. It’s been a long-awaited shot in the arm for the eurozone. The package includes injecting 1.1 trillion euros ($1.3 trillion) through the purchases of government bonds and private sector assets, worth 60 billion euros ($69 billion) a month, until the inflation rate shows signs of improvement, according to ECB president Mario Draghi.

Guillén says the goal is to essentially print money so inflation will accelerate. Investors and consumers should see prices go up in the future, so the idea is to jumpstart economic activity. But quantitative easing in the eurozone has arrived late in the game. The U.S. is winding down the QE program it embarked on six years ago when low inflation rates first started to raise alarm.

In Europe, decision makers — not just the ECB but Germany, Finland, Austria and the Netherlands — should have considered sooner the impact of weathering three recessions in eight years in the region, says Guillén. With each recession, unemployment grew. “Young people and older workers can’t easily find other jobs and it creates a very difficult social situation. People don’t have enough money to spend.”

“It’s not going to shoot us back to 2% inflation, but a looser policy is a prerequisite for a sustained move back to a moderate rate of inflation.”–Olivier Chatain

No one knows whether or how much deflation will be staved off in the eurozone with the QE plan, Chatain warns. “My impression is inflation will move a little bit, but not massively. It’s good, necessary, but coming in late. It’s not going to shoot us back to 2% inflation, but a looser policy is a prerequisite for a sustained move back to a moderate rate of inflation.”

Also important to note is that QE will not work the same in the 19-member country eurozone as it has in the U.S. “Overall, Europe’s range of possibilities and channels that can work through the economy are smaller than in the U.S. The effect could be weaker, but it’s hard to say,” notes Eckhard Wurzel, an economist with the Organisation for Economic and Co-operation and Development (OECD).

Guillén says the ECB will buy government bonds, but it won’t be on the books of the centralized monetary body. The ECB is a federation of national central banks of its member countries — if the Greek government defaults, for example, it won’t be the ECB, much less Germany, that will suffer; it will only be Greece. “The ECB is telling everybody it will be buying all these bonds, but the burden will be put on the balance sheets of the individual countries’ banks,” Guillén notes. “The market is not pooling risks in Europe. It’s letting each country handle its own risks. It’s like saying if unemployment is high in Ohio, then only Ohio will be responsible instead of the whole country. It’s a mixed message and not very reassuring.”

ButDraghi’s plan might have been the only way to pass muster with powerhouse Germany. Steffen Kampeter, German’s deputy finance minister, recently told CNBC that Europe was not facing a deflation spiral. He pointed out that in December, German consumer demand was at its peak in eight years and that Germany could exceed the 1% growth rate predicted for 2015. Nevertheless, Germany’s flash inflation rate slowed to its lowest level in five years in December. “You have people who still say there is no deflation risk, and those people took a long time to negotiate with,” adds Chatain.

Meanwhile, Switzerland — already in deflation, but not in the eurozone — recently called quits on holding its Swiss franc to a value of 1.20 to the euro just before the QE program was announced. “This is going to cause extreme pain for parts of the Swiss economy,” said David Owen, an economist with the investment firm Jefferies, in a Telegraph article.

As the Swiss economy settles down, the ECB wants to weaken the euro so Europe will be more competitive with other countries. Currently, the euro has hit an 11-year low against the U.S. dollar. “Though he wouldn’t say it explicitly, Draghi would love for the euro to be at parity with the dollar,” says Schwarz.

“The market is not pooling risks in Europe. It’s letting each country handle its own risks. It’s like saying if unemployment is high in Ohio, then only Ohio will be responsible instead of the whole country.”–Mauro Guillen

To illustrate the impact of the state of the euro, Chatain points to the example of airplane manufacturers — Airbus in France and Boeing in the U.S. “American products might be more expensive in Europe, yielding few American imports into Europe. If you’re producing goods in the U.S. and you want to sell in Europe, the currency movements make that harder,” he notes. “Conversely, European firms can offer discounts in the U.S. while keeping profitability constant.”

The China Question

Fears of a world economic slowdown are also spreading to China. For the first time in 15 years, China has missed its official growth target of 7.5%, and its consumer inflation hit a near five-year low of 1.5% in December, according to BBC News. The Chinese government has nudged the yuan down by 2% against the U.S. dollar since early November.

“China is growing very fast, but below expectations. It’s not facing deflation right now. Banks have a lot of loans on the books and can’t afford for the economy to slow down, which will essentially prevent people from improving their living standards,” explains Guillén.

As factory prices fall with the plunging oil prices, and consumer prices plod along, export prices for Chinese goods will shrink, which could potentially export that nation’s own deflationary pressures to other markets. China also has an overcapacity in many sectors, including steel, cement, chemicals and solar panels. Across Asia, debt-to-GDP ratios have spiked from 147% to 207% in the last six years, a scenario that is painfully similar to countries in the eurozone, according to the Telegraph.

However, Guillén says the “problem with Asia is not like Europe. In the last 30 years, these economies — like China, Vietnam and South Korea — have grown used to selling goods in Europe and the U.S. And looking down the road, relying on those two markets will not be enough. China needs to develop its domestic market.”

Deflationary Drag

Unfortunately, deflationary forces are hardly confined to Europe. “The eurozone is a large economy, about the same size as the U.S.,” notes Schwarz. Global trading links are so dependent that not only do exports cross oceans, but deflation can as well. Dropping oil prices have also added to the monetary pressures felt worldwide.

The ECB’s QE program should alleviate some of the stresses — but by how much? “The drop in the price level is largely driven by falling energy prices. This is a stimulus for the economy. Rebalancing of relative prices between countries also adds to low inflation,” says Wurzel. “However, the problem is there is more to the situation. Inflation could fall further, and that could get entrenched in inflationary expectations and have negative consequences.”

The deflationary contagion has the possibility to spread worldwide. Schwarz notes, “Inflation expectations have moved down, and that can be a self-fulfilling prophecy.”

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2 Comments So Far

john chew

This article is a classic example of economic ignorance and the lack of common sense–no wonder economies are in shambles across the globe.

So falling prices are bad? Try telling that to a child who goes into to buy candy or the housewife who buys groceries. Falling prices caused by rising productivity are what we pray for.

Profits will fall for businesses? Businesses make a profit on the SPREAD between their input costs and their selling prices. Who is to say input costs for SOME industries won’t fall faster than their product sales.

Whoever wrote this flunks Econ. 101. Wake up and join reality.

Edward Dodson

The most interesting assertion made in this article is as follows:

“Deflation Deflation was a major cause of the Great Depression in the U.S. and stagnation in Japan over the last two decades.”

Of course, when demand falls for goods and services, the providers thereof must make hard choices. Prices for good in inventory will be reduced as a first step. Then, unless there are means to achieving significant cost savings output will be curtailed. Capital goods will be expanded and the labor force cut. And, when this does not work relocation occurs to where the all in cost of production is lower.

What these responses to declining demand and profit margins does not provide insight to are the main drivers of our boom-to-bust economic experience. And, here the story is most often better told by historians than by economists. One such historian was Frederick Lewis Allen. Read his 1931 book “Only Yesterday” and you will come to understand what led up to the economic contraction that became the Great Depression. What he details is the history of the credit-fueled and speculation-driven character of property markets, and land markets in particular. Allen does not exactly understand why a nation’s land markets follow a cycle of boom-to-bust . He could have found out by studying the works of a contemporary economics professor named Harry Gunnison Brown. At the time, Brown was probably the top U.S. economist who wrote extensively on land markets and the destructive character of land speculation on sustainable economic growth. Brown had studied under Richard Ely at Yale but was something of a renegade because he embraced the tax reform ideas advanced by Henry George in the late 19th century.

In the post-2008 debates, Brown’s perspectives are being brought into the policy discussions by Joseph Stiglitz more than any other economist. Yet, even the prestige Stiglize brings to the debates is not being translated into changes in tax law or public policies. The beneficiaries of policies that reward “rent-seeking” from land and natural resource hoarding and speculation seem to have a solid grasp on the political agenda.

Not many other economists have either grasped the significance of the message being delivered by Joseph Stiglitz; or, if they do, have no desire to be perceived as a renegade within the profession.

Stiglitz has not gone as far as Brown or George in his analysis of land markets. He has not expressed agreement with his predecessors that the selling price of land ought to be zero and would be zero if the full potential annual rental value of land was captured to pay for public goods and services. The market will not capitalize zero actual or imputed rent into a selling price (all other things being equal). Remove the acquisition cost of access to land and natural resources that the general price level will fall, although profit margins to producers will increase with the increase in the purchasing power of customers and consumers.